The Investor Weekly has decided to provide a How-To for investors interested in making profits in both up and down markets. We will focus on some of the most popular strategies for taking advantage of a bear market. Stock shorting is the go-to option for betting against the market. However, there are many other offerings available to those with a negative market outlook.
Stock Shorting: 3 Ways to (Conservatively) Bet Against the Market
Stock Market Outlook
Since the beginning of 2022, the S&P 500 has pulled back just over 10% as of January 24th. Many investors may be questioning the strength of the overall market, rightfully so. Clearly, Mr. Market has begun to show signs of frothiness and the ability to switch directions on a daily basis. So, we will start by introducing the idea of short selling stocks, then give some other more conservative options as well.
Shorting A Stock
To begin, we need to set the scenario that investors can look for in order to put on one of these trades.
Say there’s a stock whose value has tripled over the past year due to investor panic and market hype. And say you, the investor, does not buy into all of this hype. Due to your belief that the company is highly overvalued. This is where selling a stock short comes into play. It is the exact opposite of purchasing a stock and holding it. Instead, you sell shares of the stock that you don’t own, assuming the price will eventually decrease. Then, to close out the position, you will buy back the shares that you initially borrowed in order to sell.
This method of shorting stocks is highly aggressive. Since stocks can only go down to $0, but can virtually go up to infinity it has unlimited loss potential and limited gain potential.
Stock: Company ABC
Savvy Investor A does their own fundamental/technical analysis and finds the stock is overvalued. Investor A sells short 1 share of ABC, trading at $1000, and collects that $1000.
A month later ABC is now trading at $400. Investor A is now happy with their investment and closes it out by purchasing 1 share in the market for $400. The short stock trade is now complete and Investor A has profited $600.
It is worth noting that if ABC stock continued to rise then for every dollar it increases, Investor A would incur a loss for the same amount. So, if the stock was sold short at $1000 and a month later the stock had risen to $3000, Investor A would be looking at a $2000 loss. This shows how risky this type of trade can be.
Luckily, there are other options that can leave investors less exposed.
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Option 1: Writing Covered Calls
Writing covered calls is a fair alternative to selling a stock short. In order to place this type of trade, the investor would need to own 100 shares of the respective stock. If Investor A believes the stock has performed well, but has a negative outlook for the near-term, they can sell (also referred to as write) a covered call against the shares.
Here’s what the option chain may look like for a stock you own 100 shares of. Also assume these contracts expire in a week. For some basic knowledge on covered call options, check out this video by projectfinance. So, you could sell an out-of-the-money call, say at the $915 strike price, collecting ($50 x 100 shares) $5000.
Now, this position can go one of two ways. If the price of the stock stays below $915 until the expiration date, the call will not be exercised and Investor A can keep the $5000 premium. However, if the stock price increases above $915 before the expiration date, the options contract can be exercised. So, don’t forget you still own the 100 shares that have increased in value, but now you must deliver 100 shares to the contract call owner. Therefore, you would need to either deliver the shares you own or purchase more shares using leftover cash or margin. You can find more info at this link on writing covered calls.
The main focus for writing covered calls is to identify stocks that may be facing headwinds to collect premiums on OTM call options. This is still a relatively risky strategy but offers less exposure than short selling.
Option 2: Buy Puts ATM
The next option for investors that do not have 100 shares of a stock is to buy an At The Money put option. This option is still relatively risky but still offers less downside than short selling stocks. If an investor chooses to purchase a put that expires out of the money (worthless) then the premium paid to own the put is lost. However, if the put option expires in the money, then the put holder is able to collect a gain on the position. Most people who purchase put options wind up selling them before the day of expiration.
Due to the large amount of factors that go into purchasing puts, we recommend our readers do their own due diligence to learn more about the intricacies of this strategy. We recommend checking out Long Options Strategy by Option Alpha and Buying Put Options by Jake Broe.
Option 3: Purchase Inverse ETFs
The last option and perhaps simplest of those listed is buying inverse ETFs. As you know, ETFs can track the performance of a diversified group of stocks…
**For more information on alternatives to stock shorting, take a look at The Investor Weekly Substack!
Purchasing inverse ETFs can be a great strategy for those who are new to investing. Check out our Substack for the full article and some of the top inverse ETFs available!
In the end, there are plenty of options to profit from the market going through a correction. Shorting stocks does not need to be the only available tool investors use. Once again, we recommend using a high level of due diligence when making any investment decisions. Please reach out to us if you have another bear market strategy that we may have missed!
For more in-depth articles to help you navigate your financial journey, check our Personal Finance page out!